Mastering the Real Estate Cycle

Written by: Chris Urwin | AVIVA Investors

The cyclicality of real estate creates opportunities for well-informed investors. However, determining where a market is in the cycle can be difficult, so we have developed a tool that can help investors overcome this challenge.

Source: MSCI, March 2020

Figure 1 clearly shows how yields go hot and cold, meaning capital growth is not constant. This makes total returns volatile and performance more likely to mirror equities than bond markets.

Why is real estate cyclical?

A degree of cyclicality follows from occupier demand, with rental growth tied to the performance of the underlying economy. The behaviour of investors, particularly their susceptibility to fear and greed, can exacerbate these undulations. This is true of many asset classes, but two factors make real estate more cyclical.

The first concerns the nature of development. It takes time to construct buildings, so you can have prolonged periods where the demand for office, retail, logistics or residential space far outweighs supply. But there are also periods when over-optimistic estimations of future demand lead to excess supply.

The second factor is the widespread use of leverage. Properties are real assets with an intrinsic value and therefore act as strong collateral. As a result, real estate strategies are often levered, adding to the volatility of returns.

The theory

Drawing definitive conclusions from available data is not possible. However, academic literature suggests value-added strategies fail to provide enhanced risk-adjusted returns over the long run compared to core strategies. Indeed, they have tended to underperform.  Other studies have shown that riskier strategies - value-added or opportunistic - can outperform core strategies over certain periods of time. But these studies also indicate superior returns are driven primarily by market conditions and the use of cheap debt rather than, for example, investment style or property type. This implies riskier strategies should be deployed judiciously and timing is critical to success.

"There is a time to be aggressive and a time to be defensive"

In real estate investing, there is a time to be aggressive and a time to be defensive. Generally, we should become more aggressive when the cycle is depressed and adopt a more cautious approach during times of euphoria; acting to limit potential future losses rather than ensuring full participation in gains.

Investment decisions in each stage of the cycle should also be made with an eye to likely conditions in the next stage. For various reasons, investors fail to position their portfolios in accordance with where they are in the cycle. However, it is harder than it sounds to establish which stage of the cycle the market has reached at any point in time. There are two key reasons for this: firstly, the backward-looking nature of valuations and, secondly, an array of cognitive biases.

Valuations and behaviours

Unlike in public markets, where there are observable prices for all assets, real estate values are based on appraisals. These are driven by the qualitative and somewhat subjective assessment of valuers.

"A property’s value reflects transaction pricing over the last quarter or sometimes previous two quarters"

Clearly, valuing assets in a heterogenous asset class like property is difficult and it is appropriate this is done in an evidence-based manner. However, real estate values are somewhat smoothed by backward-looking valuation methods. Typically, a property’s value reflects transaction pricing over the last quarter or sometimes previous two quarters. Furthermore, in the absence of plentiful new information, a valuer will tend to revert to the previous valuation.

Numerous studies have shown real estate values tend to be “smoothed” relative to transaction pricing and, crucially, that valuations struggle to track prices in rapidly changing market conditions. Values, therefore, fail to deliver a clear signal to investors as to how the cycle is progressing. 

Beyond valuations, the way our minds work plays a role in explaining why we fail to anticipate that tomorrow’s market conditions will be different to today’s.

Firstly, investors have been shown to anchor to current market conditions. People have short memories and struggle to realise how much change is taking place. As investors, we tend to base our assessment of future market conditions - and therefore our assessment of the present value of future cash flows - on the conditions we see today. Investors’ propensity to believe “this time is different” is generally too great, while their capacity to remember markets are cyclical is too weak.

Secondly, humans tend to base their actions on what others are doing and indulge in herd behaviour. So, if the market is displaying a high level of risk tolerance, individual investors are likely to follow suit and find ways to justify why this is appropriate.

"An investment strategy based on being fearful when others are greedy and being greedy when others are fearful sounds simple but is difficult to execute."

Therefore, an investment strategy based on being fearful when others are greedy and being greedy when others are fearful sounds simple but is difficult to execute. As investor Robert Arnott famously said: “In investing, what is comfortable is rarely profitable.” Cyclically aware investing is meant to feel difficult – and people often find ways to delay tough choices, such as, in this case, failing to identify we are at the peak of the cycle.

Building a tool kit for managing cyclical risk

We have built a cyclical risk tool that helps us establish where the market stands in the cycle in different property markets.

"Each cycle is different: their length, amplitude, causes and effects all vary"

Clearly, each cycle is different: their length, amplitude, causes and effects all vary.Nevertheless, there are enough shared characteristics in each for us to feel confident to use historic cycles as a guide to the present one.

We have brought together 15-17 different metrics to assess the main factors driving the real estate cycle in our nice city specific and overall European composite cyclical risk tool. The objective is to provide a framework for thinking about cyclical risks and a broad indication of which stage of the cycle a market is in.

Nevertheless, the tool has some limitations. In particular, it is important to use this quantitative approach alongside a qualitative assessment of sentiment. Similarly, metrics with limited datasets that have not been included in this tool should not be disregarded. Where there is relevant replacement cost data or relevant real estate investment trust market data, this should be utilised. Knowledge of the depth and ferocity of bidding for assets can also be highly informative.

Despite these caveats, this tool enables us to see that cyclical risks are relatively elevated at present in many European markets.


Today, cyclical risks are relatively elevated in the Paris office market as pricing is exceptionally strong by historical standards, building starts are at high levels and investors are showing strong risk appetite. It would seem appropriate for real estate investors to position defensively for the next stage of the cycle.


Cyclical risk is even more elevated in Berlin than Paris. The city is the only location that currently has higher cyclical risk than at the peak of the previous cycle. The Berlin economy is hot, property valuations are stretched by historical standards and there is a lot of construction activity underway. Furthermore, there are multiple proof points to suggest high risk appetite among investors.

City of London

The City of London office market is cooler than other European markets. While absolute pricing is high by historical standards and the risk appetite implied by market pricing is also high, leverage appears moderate and supply risks are under control. Unlike some other European markets, idiosyncratic factors, principally related to Brexit, have injected a degree of caution into the market.

Generally, this tool provides a clear understanding of the stage of the cycle for each market. Furthermore, portfolio positioning based on this understanding would generally have been beneficial. This tool has delivered appropriate signals in the past, such as positioning portfolios to take on leverage, vacancy and development risk when cyclical risk was low – as in the early 2000s and 2009/10. Similarly, dialling back risk exposures when our cyclical risk indicator pointed to high or very high risk in 2006/07 would have benefited performance during the subsequent downturn.

Only time will tell whether the current readings of very high risk foretell a period of marked weakness in European real estate. However, it would be prudent to be mindful of the lessons of history, remember the cyclicality of real estate and position defensively.

"It is important to understand where we are in the cycle and to adjust strategies accordingly"

The key lessons to take away are that it is important to understand where we are in the cycle and to adjust strategies accordingly. Doing so appropriately is key to achieving outperformance. And while managing cyclical risk is difficult, not least because it can be difficult to identify in which stage of the cycle a market is in, assessing cyclical risk requires a lot of relevant data alongside a qualitative assessment of sentiment. We believe our tool gives us an edge when trying to navigate the vagaries of market cycles.

Figure 2: Cyclical risk in European markets, 2001-2019

Source: Aviva Investors, February 2020

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